As is well known, when buyers and sellers attempt to trade a large quantity of stock that is disproportional to the stock's average trading volume, buyers and sellers must carefully consider their options. Following is an analysis of the main trading systems that are available for institutional traders in today's markets.
Posit is an Alternative Trading System (ATS) which seeks to manage information to facilitate large block trades. In this method, users enter orders into the trading system they want to trade including the symbol of a stock and a maximum or minimum price they are willing to accept for their buy or sell order. This system accumulates orders from several market participants over a previously specified time period and creates a master list of buy and sell orders. At a given random exact time (at different times of the day) the system matches and executes all possible contras in the system at the midpoint price of the National Best Bid and Offer (NBBO).
Pipeline Trading is another ATS that seeks to manage information to facilitate large block trades. Users of this system create and submit firm limit orders including the price, side of trade (i.e., buy or sell) and number of shares to a central order book. The trading system designates a minimum order size for each stock that the trading system will permit to be entered. Generally, high volume large cap stocks are assigned a minimum of 100,000 shares and all the other tradable stocks are assigned 25,000 shares. Orders are placed and displayed based on their designated assigned minimum trading increment of 25,000 or 100,000 shares, depending on the symbol.
In the central order book, other subscribers of the system are able to hit these displayed firm limit orders by entering firm buy or sell contras. However, the central order book does not show the buy or sell “side of trade” of any of its limit orders or their prices to its subscribers. Also, once an order reaches the central order book, it must meet an activation condition before it is offered to other users of the system.
This activation condition consists of a computer formula that calculates a “block trading range” that the central order book considers to be a reasonable price. This price range is based on average prices of prior trades for fixed amounts of prior traded volume. In order for limit orders to be activated and displayed in the central order book, the price of the limit order must fall within this block trading range. If the price of an order falls within this price range, the order is deemed fair and reasonably priced, and advertised to the users in the system by coloring the symbol as active in the central order book. When a subscriber hits an active order in the central order book, he will have to satisfy two conditions in order to execute a trade: first, his order must be contra to the order he is hitting, and second, his entered price must equal or cross the price of the sitting limit order he is hitting. If his order is not contra, then he is notified by the central order book.
To illustrate by example, assume a first party enters into the system's order book an order to buy 100,000 shares of IBM at or below a price of $89.56. (The $89.56 price and the side of the trade are hidden in the order book.) A second party enters an order to sell 100,000 shares at $89.54. The system crosses the trade at $89.55—the midpoint price between the two prices that are entered by the buyer and seller.
Thus, when a subscriber of the system wishes to grab a sitting limit order in the central order book, he must enter a price based on his guess of the price of the sitting limit order.
Pipeline only accepts very large minimum lot sizes of 25,000 or 100,000 shares. The system fails to provide for trading orders of all lot sizes.
In most cases the system creates its own synthetic bid-ask spread thereby creating its own midpoint price as well. It accomplishes this by calculating a range by aggregating fills in the public market into 25,000-share lots, calculating the highs and lows of the last five of these lots, and then calculating averages of the two extremes. The result is a synthetic bid-ask spread.
Liquidnet, another ATS, attempts to manage information to facilitate large block trades. The system continually combines all of its user's blotters (daily scheduled trades) and creates a master blotter of all the users of the system. This master blotter contains the user code, symbol, side of trade, and share size of all of the desired trades but excludes the price. The system continually attempts to match prospective buyers and sellers. Once a match is discovered, the user is notified and given the opportunity to act upon that match by initiating an anonymous negotiation through the exchange of text messages with the counter party in a private chat room. If they come to an agreement a trade is completed. Buyers and sellers must share with one another their trading interest in the private chat room in hopes of consummating a trade. Buyers and sellers are comfortable disclosing trading interest to one another because the trading system strictly limits its users to select group of traders that it feels will not take advantage of this inside information.
The system has an approximate 4% fill rate from the trading interest that is expressed in the master blotters it receives, even though probably only 20% of the master blotter is matched. Few matches result in trades.
Nasdaq Stock Market manages large numbers of limit orders at any given time during trading hours. All market participants such as investors, traders and market makers place limit orders in this trading system. Because of ever improving technology, a new method of trading is becoming more common. This new method is called “sweeping the book” or “walking the book down.” A “sweep” occurs when a limit order is priced better than the NBBO. Once entered, this type of order results in executions at multiple price points at and away from the NBBO.
To illustrate by example, assume an investor places an order to buy 5000 shares of XYZ stock at $9.00 and this quote becomes the NBB. Let us suppose further that there are buy orders for 1000 shares at $9.95 and 5000 shares at $8.75 and 500 shares of XYZ stock at $8.70. A minute later a second order comes in to sell 20,000 of XYZ stock at $8.75. This sell order first grabs the investor's order of 5000 shares and then grabs the other limit orders of 1000 at $9.95 and 5000 shares at $8.75. Any limit order that is priced equal or greater than $8.75 will be grabbed until the 20,000 order is filled. In this example, this results in filling 11,000 shares of the sell order. The remainder of 9000 shares becomes the NBO and the new NBB becomes $8.70. In less than a second, the investor has a fill at $9.00 but has already taken a financial loss in the position of 3.33% or $1,500 on a $45,000 purchase.
This investor who placed the limit order to buy 5000 shares of XYZ stock was “picked off” by the sweep. Although he got a fill at his price, he regretted placing the order because of his immediate financial loss. Sweeping increases price volatility and diminishes the ability of traders to buy and sell at stable prices. This results in fewer limit orders being placed in this type of trading system. Nasdaq Stock Market fails to protect limit orders from “being picked” off during a sweep. This increases the costs of limit order placement and thus reduces liquidity in this market.
The New York Stock Exchange (“NYSE”) is another trading system that attempts to manage information to facilitate large block trades. This system relies on having a person (specialist) at a specific real estate location called a “post.” These posts are located on the floor of the NYSE. The specialist stands around his post and takes orders from floor brokers. Floor brokers represent their institutional customers with buy and sell orders. Through verbal and hand signals, floor brokers communicate with the specialists. In many instances there are several floor brokers standing, yelling and chattering around the specialist post. The purpose of this yelling and chattering is to communicate buy and sell orders of their institutional customers to the specialist and other floor brokers. Floor brokers share their institutional customers' buy and sell orders with other floor brokers in attempt to fill their customers' orders. In many instances a floor broker may discover that other floor brokers are attempting to find contra parties for large orders on the same side of trade (buy or sell). When this occurs it reveals to many of the floor brokers hanging around the booth that one sided buy or sell trading interest exits and this trading interest wants to immediately come into the market. Once this trading interest is revealed, new smaller (buy or sell) orders are generated on the same side and are immediately placed in the market ahead of the larger orders that are sitting on the sidelines still looking for a contra. These smaller orders move the price of the stock against the large orders sitting on the sideline. This information leakage increases the trading costs for institutional investors that trade listed stocks. The open outcry trading system of the NYSE fails to operate without leaking valuable inside trading interest to unintended third parties, resulting in increased costs for traders who use this trading system.
When a limit order is entered into the Nasdaq Stock Market and New York Stock Exchange the market is impacted in all cases by an increase in the buy or sell trading interest. Nasdaq Stock Market allows traders to show only a portion of their limit order to the market. This practice of hiding shares reduces the market impact of limit order placement. However, it introduces other problems for traders. Hiding shares reduces the chances of attracting a contra party that can take out the entire size of the order with reserve shares in one trade. If a trader sends an order that is larger than what is required to take out the limit order with reserve shares, he impacts the market by becoming the quote of the NBBO. This results in needlessly displaying left over shares to the market. Nasdaq Stock Market and New York Stock Exchange fail to prevent market impact when limit orders are placed into their trading systems.
In the Nasdaq Stock Market and NYSE limit orders sit in order books and wait for a contra party to trade with. Generally, the limit order has a good chance of execution only if the price reaches the best bid or ask price. Occasionally, limit orders are executed away from the best bid or ask price due to a market sweep. Limit orders that are priced at the NBBO have much greater chance of execution than limit orders that are priced inferior to the NBBO. This situation basically creates two different types of limit orders, one type that is priced at the NBBO and another type of limit order that is priced away from the NBBO. The current trading systems of Nasdaq and NYSE do not differentiate between these two types of limit orders. Nasdaq and NYSE trading systems fail to provide any incentive to traders to place limit orders away from the NBBO and thus reduce the amount and size of limit orders that could be placed into their order books.
Posit, Pipeline, Liquidnet, Nasdaq Stock Market and NYSE trading systems have flaws in how buyers and sellers communicate with one another, how these systems determine the final execution price of matched orders and how these systems protect information generated by order placement.
Accordingly, there is a need in the art for a system and methods that improve communications, improve price discovery, prevent information leakage and protect limit orders from sweeps, which will result in better executions.